After 48 years, I think Warren Buffett’s 4 ‘rules’ are still relevant

In his 1977 letter to Berkshire Hathaway‘s shareholders, Warren Buffett explained how he evaluated businesses. This month, I used the four ‘rules’ to help me decide whether to buy Babcock International Group (LSE:BAB) shares.

Let’s look at each in turn.

Rule 1 – “One that we can understand“

To be honest, the idea that we should only invest in what we understand is the one I struggle with the most.

Although I know that Babcock is an international defence company that designs and builds warships, and supports the UK nuclear submarine fleet, I have no personal knowledge of the sector. I’ve never worked in the industry and I haven’t a clue how any of these things are made.

But does that matter? Despite my sector-specific ignorance, I know that a company makes money by selling something for more than it costs to make. I’m also aware it should keep a tight rein on its working capital and carefully manage borrowings.

Using these measures, Babcock’s in good financial shape.

Both revenue and earnings are growing. And its balance sheet remains healthy. One analyst is estimating that the group’s net debt, at 31 March, is equal to 0.3 times EBITDA (earnings before interest, tax, depreciation and amortisation). Four years earlier, it was 2.4 times.

But despite my enthusiasm, I have to acknowledge that it’s racked-up nearly £200m of cost overruns on a contract with the Royal Navy, which is a bit of a stain on its record.

Rule 2 – “Favourable long-term prospects“

As worrying as this might be, it’s a fact that governments around the world are spending more on defence.

From April 2027, the UK government’s pledged to spend 2.5% of Gross Domestic Product on its army, navy and airforce. Babcock’s the second biggest supplier to the Ministry of Defence so it should benefit from this.

The European Union’s also planning a huge increase in its expenditure.

At $2.46trn, last year’s global defence spending was the highest on record. This is justified on the grounds that the primary duty of a government is to protect its people. Of course, nobody ever admits to being the aggressor.

But I know some won’t invest for ethical reasons. Reducing the pool of potential investors could limit share price growth.

Rule 3 – “Operated by honest and competent people“

Although I don’t know any of the group’s directors personally, they appear to have a good reputation and plenty of relevant experience.

CEO David Lockwood has been widely credited with turning round the company that — prior to his appointment — was known for some ill-fated acquisitions, dubious accounting practices and its poor reputation.

Since his arrival in September 2020, the group’s share price has risen 275%.

Rule 4 – “Available at a very attractive price“

Based on consensus forecasts for the current financial year, compared to its FTSE 100 peers, Babcock’s shares appear to offer excellent value with a price-to-earnings (P/E) ratio of 18.7, comfortably below that of its nearest rival, BAE Systems (24.5). It’s similar looking further ahead.

You’ve probably worked out by now that I did buy some shares in Babcock. That’s because, I think the group ticks all four of Warren Buffett’s boxes to one degree or another.